Early Stage Funding with Convertible Notes

We have started multiple companies, advised many early stage companies, invested in startups, and been involved in raising money from individuals, angel funds, VCs, and strategic investors. While we are definitely not investment bankers or VCs at Levvel, we have had a pretty broad exposure to all sorts of private placement/investment deals. The terms, deal structures, and size of investments that we’ve seen vary tremendously. In this blog we’re going to talk about valuation of early stage companies and in particular about our favorite security/deal structure to use.

People invest in ideas/startups for a variety of reasons. Some are professionals and bring the rigor typically seen in a private equity or venture capital fund to the process. Others invest because they saw a friend reap a 100X return on a private investment. Or maybe these investors feel like they need to invest in the future of their neighborhood, city, or industry. Others are part of the 3 F’s that often invest in companies (friends, family, and fools). Regardless of the motivation, they all do really hope to see the entrepreneurs they back become wildly successful and make some money in the process.

The first decision that an investor and an entrepreneur must make is what sort of instrument to use (and often at the same time they’ll figure out how much to invest and some sort of valuation metric). This can take the form of common equity (equivalent to founders shares), preferred equity (pays a dividend typically and also contains a liquidation preference over common shares), a note, or possibly even a call option (the right to buy shares later at an agreed upon price). Typically there are hybrid securities that are used in which an instrument with a preference (such as preferred equity or a note) also contains a mechanism to leverage the upside of a common equity instrument (such as an agreed upon conversion/participation right or by attaching warrants to purchase more shares upon redemption of the note). Regardless of the instrument chosen, a typically difficult decision must be made on valuation.

For most early stage investors, valuation is tough. The investor is possibly inexperienced in valuing a company, but even experienced investors find it difficult to truly measure the value of a company with little or no revenue, unproven technology, often in an unproven market, and with a team that has members that may or may not be in it for the long haul. Valuation is hugely important in the case of common shares, and often times both the entrepreneur and investor are too afraid to leave money on the table. This can lead to delays in reaching an agreement on deal terms, which in a fast-paced tech startup can kill an idea before v1 ever ships. On the flip side, a pure note is not often a great vehicle since the risks in early stage companies are often very high and the rates would have to be significant in order to attract a would be investor.

Because of this inherent difficulty, the hybrid investments I mentioned have become increasingly popular. I will focus on the convertible note, but a clever application of conversion/participation rights to preferred shares or attaching warrants to a note can easily achieve a similar net effect. In a convertible note, the investor lends money to the entrepreneur. They will often attach several covenants to the debt and possibly ask for a board seat. But the key feature for the note is that it can be converted from a note to shares upon some external trigger. Typically that trigger will be an equity investment of some type. And the note will often be anchored to the equity price less some pre agreed upon discount, allowing a more seasoned investor to properly value the company, or the company to reduce many of its risk factors (technology, market, or talent risk).

For example, suppose you wish to raise $20,000 from your well healed uncle in order to fund the development of a great new app you’ve come up with. He thinks he should get 50% of your company for this investment, which would imply a $40,000 valuation. You think he should get 0.2%, which implies a $10,000,000 valuation. You may both be right, or both wrong, or possibly something in between. But clearly the valuation expectations are so widely apart that you probably will not agree on a common equity approach. Instead, your smart VC buddy from Palo Alto proposes a different approach. Your uncle invests $20,000 and gets a promissory note in return that pays a 9% interest rate. If you later raise at least $200,000 in equity funding, the note will convert to the same equity sold to the new investor(s) at a 10% discount.

Suppose your uncle agrees to this, and a year later you raise $200,000 from the local angel fund after landing your first big customer. They have given you a $2,300,000 valuation (i.e. they are purchasing an 8% stake). For this example, assume you sell them 100,000 shares (at $2 each). Your uncle now has a note worth $21,800 ($20,000 face value plus 9% interest for one year). The note will convert to shares at a price of $1.80 per share ($2 less 10% discount). So your uncle converts his note to 12,111.11 shares. The value of those shares is immediately $24,222.22. So clearly he has reaped a decent return on his investment (21.1% in a single year). But more importantly, he now is a common shareholder and will participate in the upside the angel investors believe exists and also can take comfort in the fact that you have a customer and have a product.

This is a simplified example, but clearly the hybrid instrument reduces the friction in initial valuation. Further protections such as equity caps or graduated discount schedules can help to further reduce risks or concerns either party may have. It is a more complex instrument meaning some investors will need to be educated on how it works, but overall my experience is that this approach helps prevent over or under valuation at a time that it is nearly impossible to value a company. If you have a willing investor or wish to invest in some idea that may be the next big thing, you should strongly consider a convertible note.